How do YOU calculate COC?

Question

The calculation for CAP rate is clearly defined so everyone should be calculating it the same way.  There are obvious benefits to having a uniform calculation.  On the other hand, Cash on Cash Return seems to be calculated a variety of ways.  I think most people know to include all your expenses in the numerator but it's the denominator that doesn't seem to be very consistent.  What do you include in the denominator?  I'm sure everyone includes the down payment (assuming its financed) and closing costs but do you typically include cash reserves?  I believe cash reserves should be included since this is money you typically can't touch for other purposes.  You didn't technically pay this amount to anyone but it is part of the "investment" you need to be a conservative investor.  I personally hold about $5K per property in reserves.  When I remove this from the denominator, my COC increases by 2%-3% which is quit significant!  Are you calculating COC the same way?

Roy N. · Answer

@David Hodge

While the CAP appears simple and consistent on the surface, it is one of the most misused and deceptive ratios in investing.   It is only meaningful within a given local area as a means of comparing what folks are paying for similar cash flows.  Even then, it needs to be calculated using the same methodology in each instance to provide an apples to apples comparison.  Finally, since CAP rate is used to compare cash flows - properties which are valued based upon the income they produce - it is not really a useful metric for residential real estate which is valued based upon comparative sales.

Cash on Cash is a related ratio which takes into account leverage.  Instead of the full capital cost of the property in the denominator you use your cash outlay (downpayment plus initial capital expenditures to place the asset into service).

Your cash reserves would not be included as they are merely a pledge and have not been spent on the property.

Now, cash-on-cash return ratio has its own limitations, the principal one being it is only a single point in time.   If you want to evaluate {"project"} your investment into the future, you will need to carry out an analysis of discounted cash-flows over the period being examined.

Roy N. · Answer

@David Hodge

Underwriting to (M)IRR should give you a better understanding of the business, but even then you still need confidence in your inputs and any assumptions: "garbage in, means garbage out".

David Hodge · Answer

Thank you all for the responses!

@Roy N. I appreciate the detailed response.  I've been including my reserves for capex in the denominator AND expected average annual capex in the numerator so I think I've been double counting capex.  My projected return was getting hit twice. On paper my returns are looking a little better now! Regarding the future income, I also do calculate the IRR to make sure that's lookin good too.

@Kevin Trumbull just so I understand.. you include the reserve in the denominator when analyzing a deal but you don't include the capital expenses that will pull from the reserve in that initial analysis?

Kevin Trumbull · Answer

@Chris Harpstrite. Can you PM me the name of your lender, sounds like an interesting loan product.

For the thread, I include cash reserves in my CoC calculation when evaluating a potential deal, but only include spent cash for my yearly 'actual' CoC calculation.

Chris Harpstrite · Answer

@Roy N. I don't really know the difference between the two. What my lender did was use the equity I had in a different investment property as my down payment. It wasn't a line of credit or anything like that, he called it bridging equity and as I pay down the loan (he said in about a year) they would release that equity and I would be able to use it again.

Roy N. · Answer

What do you mean by you bridged equity?  Did the Vendor, or lender, accept a pledge of equity in lieu of a downpayment (ie. 100% leveraged) or did you draw down on the equity in one or more properties to form your downpayment?

Chris Harpstrite · Answer

How would you calculate if you didn't have to put anything down? On my last two SF properties I was able to bridge equity from my other investments and didn't have to put a penny down.

Jason Mak · Answer

I think i get what you are saying...here's my take:

For pro-forma purposes, yes, absolutely include the capital reserves as that is what you "expect to spend" in worse case scenario

For historical performance purposes, then, you can make an argument to NOT include it since you never spent the money, but unless you distributed that money back to your investor, then you may as well include it too

that's just how i would do it...

Russell Brazil · Answer

@David Hodge I would not include reserve funds as part of the equation.  Most of my reserve funds are in the stock market earning their own return. Also different individuals are going to have bigger or smaller reserve funds than others.  I dont necessarily allocate any dollar amount to a reserve for each property.

Matt Motil · Answer

I think an investor that wants to be in this game for the long haul is going to have reserves, and those should be held as liabilities against the property, so it should deduct from the numerator, in my opinion.

How do YOU calculate COC?

Most Popular Reply